Gary Dessler

tenth edition

Chapter 12

Part 4 Compensation

Pay for Performance and Financial Incentives

2005 Prentice Hall Inc. All rights reserved.

Motivation, Performance, and Pay

Incentives
Financial rewards paid to workers whose production exceeds a predetermined standard.

Frederick Taylor
Popularized scientific management and the use of financial incentives in the late 1800s.
Systematic soldiering: the tendency of employees to work at the slowest pace possible and to produce at the minimum acceptable level.

Individual Differences
Law of individual differences
The fact that people differ in personality, abilities, values, and needs. Different people react to different incentives in different ways. Managers should be aware of employee needs and fine-tune the incentives offered to meets their needs. Money is not the only motivator.

Employee Preferences for Noncash Incentives

*The survey polled a random nationwide sample of 1,004 American adults. Among those polled, 851 were working or retired Americans, whose responses represent the percentage cited in this release. The survey was conducted June 4 7, 1999, by Wirthlin Worldwide. The margin of error is 3.1%. Responses total less than 100 because 4% responded something else.
Source: Darryl Hutson, Shopping for Incentives, Compensation and Benefits Review, March/April 2002, p. 76.

Figure 121

Needs and Motivation

Abraham Maslows Hierarchy of Needs
Five increasingly higher-level needs:
physiological (food, water, sex) security (a safe environment) social (relationships with others)

self-esteem (a sense of personal worth)

self-actualization (becoming the desired self)

Lower level needs must be satisfied before higher level needs can be addressed or become of interest to the individual.

Needs and Motivation (contd)

Herzbergs HygieneMotivator theory
Hygienes (extrinsic job factors)
Inadequate working conditions, salary, and incentive pay can cause dissatisfaction and prevent satisfaction.

Motivators (intrinsic job factors)

Job enrichment (challenging job, feedback and recognition) addresses higher-level (achievement, selfactualization) needs.

The best way to motivate someone is to organize the job so that doing it helps satisfy the persons higher-level needs.

Instrumentality and Rewards

Vrooms Expectancy Theory
A persons motivation to exert some level of effort is a function of three things:
Expectancy: that effort will lead to performance. Have to have the skills to do the job Instrumentality: the connection between performance and the appropriate reward. Goal must be attainable Valence: the value the person places on the reward.

Motivation = E x I x V
If any factor (E, I, or V) is zero, then there is no motivation to work toward the reward. Employee confidence building and training, accurate appraisals, and knowledge of workers desired rewards can increase employee motivation.

Types of Incentive Plans

Pay-for-performance plans
Variable pay (organizational focus)
A team or group incentive plan that ties pay to some measure of the firms overall profitability.

Variable pay (individual focus)

Any plan that ties pay to individual productivity or profitability, usually as one-time lump payments.

Types of Incentive Plans (contd)

Pay-for-performance plans
Individual incentive/recognition programs Sales compensation programs Team/group-based variable pay programs

Organizationwide incentive programs

Executive incentive compensation programs

Individual Incentive Plans

Piecework Plans
The worker is paid a sum (called a piece rate) for each unit he or she produces.
Straight piecework: A fixed sum is paid for each unit the worker produces under an established piece rate standard. An incentive may be paid for exceeding the piece rate standard. Standard hour plan: The worker gets a premium equal to the percent by which his or her work performance exceeds the established standard.

Individual Incentive Plans (contd)

Pro and cons of piecework
Easily understandable, equitable, and powerful incentives Employee resistance to changes in standards or work processes affecting output Quality problems caused by an overriding output focus Possibility of violating minimum wage standards Employee dissatisfaction when incentives either cannot be earned due to external factors or are withdrawn due to a lack of need for output

Individual Incentive Plans (contd)

Merit pay
A permanent cumulative salary increase the firm awards to an individual employee based on his or her individual performance.

Merit pay options

Annual lump-sum merit raises that do not make the raise part of an employees base salary. Merit awards tied to both individual and organizational performance.

Individual Incentive Plans (contd)

Incentives for professional employees
Professional employees are those whose work involves the application of learned knowledge to the solution of the employers problems.
Lawyers, doctors, economists, and engineers.

Decisions can be challenging

These individuals are already well paid and are driven to succeed

Possible incentives
Bonuses, stock options and grants, profit sharing Better vacations, more flexible work hours Improved pension plans Equipment for home offices

Individual Incentive Plans (contd)

Recognition-based awards
Recognition has a positive impact on performance, either alone or in conjunction with financial rewards.
Combining financial rewards with nonfinancial ones produced performance improvement in service firms almost twice the effect of using each reward alone.

Day-to-day recognition from supervisors, peers, and team members is important.

Individual Incentive Plans (contd)

Online award programs
Programs offered by online incentives firms that improve and expedite the awards process.
Broader range of awards More immediate rewards

Information technology and incentives

Enterprise incentive management (EIM)
Software that automates the planning, calculation, modeling and management of incentive compensation plans, enabling companies to align their employees with corporate strategy and goals.

Incentives for Salespeople

Salary plan
Straight salaries
Best for: prospecting (finding new clients), account servicing, training customers salesforce, or participating in national and local trade shows.

Commission plan
Pay is only a percentage of sales
Keeps sales costs proportionate to sales revenues. May cause a neglect of nonselling duties. Can create wide variation in salespersons income. Likelihood of sales success may linked to external factors rather than to salespersons performance. Can increase turnover of salespeople.

Specialized Combination Plans

Commission-plus-drawing-account plan
Commissions are paid but a draw on future earnings helps the salesperson to get through low sales periods.

Commission-plus-bonus plan
Pay is mostly based on commissions. Small bonuses are paid for directed activities like selling slow-moving items.

Organizationwide Variable Pay Plans

Profit-sharing plans
Cash plans
Employees receive cash shares of the firms profits at regular intervals.

The Lincoln incentive system

Profits are distributed to employees based on their individual merit rating.

Deferred profit-sharing plans

A predetermined portion of company profits is placed in each employees account under a trustees supervision.

Organizationwide Variable Pay Plans (contd)

Employee stock ownership plan (ESOP)
A corporation annually contributes its own stock or cash (with a limit of 15% of compensation) to be used to purchase the stockto a trust established for the employees.
The trust holds the stock in individual employee accounts and distributes it to employees upon separation from the firm if the employee has worked long enough to earn ownership of the stock.

Advantages of ESOPs
Employees
ESOPs help employees develop a sense of ownership in and commitment to the firm, and help to build teamwork. No taxes on ESOPs are due until employees receive a distribution from the trust, usually at retirement when their tax rate is lower.

Shareholders of closely held corporations

Helps to diversify their assets by placing their shares of company stock into an ESOP trust and allowing them to purchase other marketable securities for themselves in their place.

Advantages of ESOPs (contd)

The company
A tax deduction equal to the fair market value of the shares transferred to the trustee. An income tax deduction for dividends paid on ESOP-owned stock. The Employee Retirement Income Security Act (ERISA) allows a firm to borrow against employee stock held in trust and then repay the loan in pretax rather than after-tax dollars. Firms offering ESOP had higher shareholder returns than did those not offering ESOPs.

At-Risk Variable Pay Plans

At-risk variable pay plans that put some portion of the employees weekly pay at risk.
If employees meet or exceed their goals, they earn incentives.
If they fail to meet their goals, they forgo some of the pay they would normally have earned.

Short-Term Incentives for Managers And Executives

Annual bonus
Plans that are designed to motivate short-term performance of managers and are tied to company profitability.
Eligibility basis: job level, base salary, and impact on profitability Fund size basis : nondeductible formula (net income) or deductible formula (profitability)

Individual awards: personal performance/contribution

Long-Term Incentives for Managers And Executives

Stock option
The right to purchase a specific number of shares of company stock at a specific price during a specific period of time.
Nonqualified stock option Most popular Indexed option Exercise price fluctuates with the performance of a market index Premium priced option Exercise price is higher than the stocks closing price

Options have no value (go underwater) if the price of the stock drops below the options strike price (the options stock purchase price).

Other Executive Incentives

Golden parachutes
Payments companies make to departing executives in connection with a change in ownership or control of a company.

Guaranteed loans to directors

Loans provided to buy company stock. A highly risky and now frowned upon practice.

Creating an Executive Compensation Plan

Define the strategic context for the executive compensation program. Shape each component of the package to focus the manager on achieve the firms strategic goals. Create a stock option plan to meet the needs of the executives and the company and its strategy. Check the executive compensation plan for compliance with all legal and regulatory requirements and for tax effectiveness. Install a process for reviewing and evaluating the executive compensation plan whenever a major business change occurs.

Why Incentive Plans Fail

Performance pay cant replace good management. You get what you pay for. Pay is not a motivator. Rewards punish. Rewards rupture relationships. Rewards can have unintended consequences. Rewards may undermine responsiveness.

Rewards undermine intrinsic motivation.

Implementing Effective Incentive Plans

Ask: Is effort clearly instrumental in obtaining the reward? Link the incentive with your strategy. Make sure effort and rewards are directly related. Make the plan easy for employees to understand. Set effective standards. View the standard as a contract with your employees. Get employees support for the plan. Use good measurement systems. Emphasize long-term as well as short-term success. Adopt a comprehensive, commitment-oriented approach.